My column this week highlighted the huge disparity between the financial health of Canadian consumers (terrible) and U.S. households (largely deleveraged and ready to spend) but I didn't get into the reason why the disparity exists: China.
The chart below highlights the tremendous effect of China's mid-crisis debt explosion on Canadian asset prices. Materials stocks – which made up 40 per cent of the S&P/TSX Composite index at the time – were yanked out of the doldrums as the Middle Kingdom's monetary expansion grew.
China increased its money supply by 60 per cent in the twelve months ending November 2009 by ordering the country's banks to lend to any business owner that came through their door. These funds were used primarily for infrastructure development and real estate construction. The result was a giant surge in the global demand for raw materials, as well as in their prices.
With help from our strong domestic financial system, the renewed resource boom allowed the Canadian economy to escape the debt deleveraging process that took place south of the border. Between 2008 and 2010, domestic GDP growth averaged 0.6 per cent annually, well above the average 0.2 per cent annual contraction in the U.S. economy.
China M2 vs S&P/TSX Materials index
SOURCE: Scott Barlow/Bloomberg
A debt deleveraging process in Canada may be inevitable, but it isn't necessarily imminent. Gluskin Sheff + Associates Inc. economist David Rosenberg published a report Tuesday noting that by some measures – net worth to income and the debt service ratio, for example – domestic household debt can be sustained.
But, in my opinion, there are two big conditions attached to Mr. Rosenberg's sanguine outlook on household balance sheets. One, interest rates have to stay low enough to make mortgage payment and other debt-service charges affordable. The other is that China has to maintain enough growth to keep commodity prices high, and to keep struggling resource companies solvent.
I've noted previously that resources play a smaller role in the economy than they do in the S&P/TSX Composite. Still, the economic effects of a slower China and weakening commodity prices would be significant, and painful, for Canada. Declining job growth in the resource sectors themselves would only be the tip of the iceberg. The finance industry would be starved of the big checks from its investment banking business, which is dominated by mining and energy companies. And investors themselves would endure a period of flat or even negative returns.
The last six months have seen interest rates climb and China's economic growth slow, heightening the risk of deleveraging and a slowing domestic economy. A U.S.-style financial crisis is likely not in the cards for us, but the growing economic risks should be taken seriously by Canadian investors and businesses.